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The Bank of England cut its growth forecasts and said inflation would fall rapidly in 2012, indicating monetary policy will need to remain ultra-loose this year and next as the global economy struggles to stabilize.
In its quarterly Inflation Report, however, the central bank gave little indication it was about to further loosen policy through another round of quantitative easing, money-printing by another name.
"Since we last met, the mood in markets has taken a sharp turn for the worse," BoE Governor Mervyn King told reporters. "In the (monetary policy) committee's view the weakness in underlying activity is likely to be somewhat more persistent than previously expected.
"There are a number of headwinds to world and domestic growth over the forecast period, not least the public and private debt overhang, and these headwinds are becoming stronger by the day."
The U.S. Federal Reserve on Tuesday took the unprecedented step of saying it was likely to keep interest rates near zero for at least two more years, and said it would consider further steps to help growth, while the European Central Bank overcame some internal opposition to begin buying the bonds of debt-laden Italy and Spain this week.
King stopped short of promising to freeze rates at the current record low of 0.5 percent but noted that markets were pricing in only one quarter-point rate rise by the end of 2012.
That, and his emphasis on the downside risks, drove sterling lower and sent British government bond futures more than a point higher on the day.
"It is important to remember that the report itself was compiled before the recent market volatility and so the forecasts will not have reflected the recent plunge in equities and commodity prices," said James Knightley, an economist at ING. "This would probably add to the downside risks to these new numbers."
The BoE forecast that inflation would peak around 5 percent later this year-the same as it predicted in May-before falling steadily to 1.8 percent in two years time, a shade lower than it expected three months ago. The BoE targets 2 percent inflation.
This marked fall in inflation comes despite the fact that much less monetary tightening is factored into the BoE's forecasts than in its May projections.
Short-term market interest rates are only predicted to rise to 0.8 percent by the end of 2012-implying just one quarter point increase in rates, compared to a 1.7 percent rate in May's forecast.
There appeared to be more consensus on the 9-member Monetary Policy Committee than three months ago, with the report noting "a range of views" about the outlook on growth and inflation, rather than the "wider than usual" range referred to in May.
EURO ZONE THREAT
The BoE said there were substantial downside risks to Britain's economic recovery, the biggest of which came from the euro zone fiscal crisis.
"Were they to crystallise, the risks emanating from the euro area have the potential to have a significant impact on the UK economy," the BoE said. The risk of this was hard to quantify, and therefore not factored into the BoE's forecasts, it said.
Nonetheless, it still cut its growth forecast for 2011, and to a lesser degree, going forward. By the fourth quarter of 2011, the BoE now sees an annual rate of growth of 2.0 percent, down from 2.5 percent in May.
After two years, growth is forecast to be running at an annual rate of around 2.7 percent, a fraction lower than in May.
"Assuming 0.8 percent market rates for the fourth quarter of 2012 would imply an expectation of a rise in official rates beginning to seep into the market at the end of next year. Which would imply a rate rise only in early 2013. They're probably going to keep the rates low well into 2013 and probably beyond that," said Stephen Lewis, UK economist at Monument Securities.